Here is Bank of America’s case for buying unloved UK equities

Strategists at the US bank believe UK stocks are a good investment later in the economic cycle

By

Victor Reklaitis

May 15, 2018 Updated: 2:23 p.m. GMT

The major stock benchmarks — European, American, and others — haven’t exactly hit it out of the park this year. In fact, they’ve been whiffing a lot thanks in part to investor fears that it’s late in the recovery, with the nine-year-old US expansion ranking as the second longest in US history, MarketWatchreports.

Investors with such worries ought to consider a broad bet on the United Kingdom’s stocks, say Bank of America Merrill Lynch strategists. The country’s FTSE 100 works as a “later-cycle trade given its heavy weight in commodities and defensives”, writes the BAML team in a recent note. The strategists say they’re closing out their wager on European healthcare stocks and dividend payers, instead switching into UK equities.

Commodities producers tend to outperform when an expansion gets on in years, and the FTSE has plenty of them. Oil and gas companies such as BP make up 16% of the index, while basic resources plays such as miner BHP Billiton account for 8%. As for playing defense, 21% of the equity index’s weighting goes to food and beverage companies, telecoms, healthcare, and utilities — typically resilient sectors.

The BAML strategists’ bet on Britain is contrarian, and they like it that way. “We think the current entry point is attractive from a sentiment perspective,” write James Barty, Ronan Carr, and Jack Iacovou. UK equity funds have seen huge outflows over the past two years, and BAML’s March survey of fund managers showed allocations to British stocks at an all-time low, the strategists point out. April’s edition showed an improvement, and that could indicate attitudes are “turning the corner”, they say.

The outflows have followed the country’s June 2016 vote in favour of Brexit, or leaving the European Union. The departure, due to officially take place in March, has led Allianz strategists to caution that the UK is “set to endure a significant period of economic uncertainty and weakness”. And many strategists, if not most, have issued similar warnings.

But BAML’s team emphasises that the FTSE is one of the only major stock benchmarks offering a dividend yield above 4%. They also stress that the Brexit-battered pound should continue to help the index.

‘Clearly we are later cycle, but that does not mean we are at the end of the cycle, and the difference is crucial for investors’

The weakened pound has been providing a boost because the index’s multinational companies generate about 70% of their revenue in foreign currencies, so there’s a lift when those sales are switched into sterling. The British currency recently changed hands at about $1.36, down 9% against the dollar from its pre-Brexit-vote level around $1.50. “Further dollar gains, as our FX strategists forecast, should underpin additional earnings momentum and outperformance,” Barty and his colleagues say.

The FTSE 100 is up 4% over the past 12 months, lagging the S&P 500’s gain of 14%, but topping the Stoxx Europe 600’s drop of 1%. The British blue-chip barometer trades at 14 times forward-year estimated earnings, below the S&P’s multiple of 17 and the Stoxx 600’s PE of 15.

The most popular US-listed ETF for betting on UK stocks is the iShares MSCI United Kingdom ETF, which has attracted $2bn in investor money. MSCI’s UK index is “very similar” to the FTSE 100, say BAML’s strategists. Competing ETFs include the First Trust United Kingdom AlphaDEX Fund and the iShares Currency Hedged MSCI United Kingdom ETF.

It’s late innings for the global expansion, not game over, reckon BAML’s strategists. “Clearly we are later cycle, but that does not mean we are at the end of the cycle, and the difference is crucial for investors,” they say.